By: Adam – Buddy5000 – If you’re like me, you may wonder how credit card companies manage to give such generous rewards and still stay in business.  How has the loophole grown so big that we can get such valuable rewards from credit cards?  Who is on the other end of that equation?

To understand that, we’re going to take a dive into the world of credit card processing.

Here’s Part I of our three part series, Who Really Pays for Your Rewards?

I’ll use my Alaska Airlines Signature Visa Card as an example.  I received 30,000 miles just for signing up and spending $1,000 in the first 90 days.  I’m using that mileage to fly free, round-trip to Alaska this summer.  And, I can use the annual companion pass to take a guest to Hawaii, round-trip, for only $121.

In fact, you can apply now for the Alaska Airlines Signature Visa Card and get your free travel too!

But how is Bank of America (the card issuer) going to make the money back they’re losing by giving me all this free stuff?  There’s more than one answer, but the story starts with transaction fees.

How do the fees work?

Let’s say I buy some bananas at a local grocery store with my Alaska card.  The grocery store is paying two separate fees to accept my credit card: a processing fee and an interchange fee.

The processing fee is negotiable; this is how the processor makes their money.  Large merchants have bargaining power and put pressure on their processors to lower the fee per transaction.  This fee compensates the processor for building out the technical capabilities to “process” the transaction.  These fees are usually a small part of the overall fee

The interchange fee is not negotiable. These fees make up the bulk of the overall fee paid by the merchant.  Visa sets this fee, based on the merchant’s industry and customer’s card type.  Visa passes this fee on to Bank of America (the issuing bank), and Bank of America turns around and pays Visa for their services.

But… how does Visa decide the interchange fees?  Well, they have a handy dandy 22 page set of tables that explains their fees.  (You can see for yourself by visiting this link.  The interchange fee varies both by the merchant’s industry (fast food vs. gas station, etc.) and the customer’s card type.

So, what are the different interchange card categories for Visa?  Going with my local grocery store example, these are Visa’s interchange fees (by card category) for a small “Supermarket.”

• Cash (N/A): No fee
• Debit Card (from a large bank): 0.05% + $0.21 per transaction
• Debit Card (from a smaller bank): 1.15% + $0.15 per transaction (capped at $0.35)
• Basic (no rewards) Credit Card: 1.22% + $0.05 per transaction
• Traditional Rewards Credit Card: 1.48% + $0.10 per transaction
• Signature Credit Card: 1.48% + $0.10 per transaction
• Signature Preferred Credit Card: 2.10% + $0.10

So, the Alaska Airlines “Signature” Visa Card costs the merchant 1.48% + $0.10 per transaction.  That’s 0.26% + $0.05 per transaction more than a basic, no rewards credit card.  It’s even more expensive than the fees on a debit card from your local bank, which is even more expensive than the fees on a debit card from a large bank (with $10 billion+ in assets; e.g. Chase, Wells Fargo, etc).  Finally, those plastic payment methods are all more expensive to process than having a customer that just pays in cash.

What does the interchange fee cover?

Lots of things. Bank of America has the risk of not collecting the balance on my credit card if I don’t pay, or if I declare bankruptcy.  They also are floating all the money I’m using to buy stuff until I pay my bill.  But, as you can see from the rates above, rewards play a big part in that expense, so much so that different interchange fee categories have been set, to help Bank of America make more money on the high rewards cards.

How do the merchants react?

Now, as a merchant, am I going to just “take a loss” on the extra credit card fees?  No, not any more than companies “take a loss” when the price of anything else in their business goes up.  So who ends up paying for all the rewards?  How do the merchants cover the costs of these high fee reward credit cards?

The answers to those questions, and more, will be covered in our next article, Looking Through the Loophole: Who Really Pays for Your Rewards? (Part II)

Did you know that merchants pay more fees when you use your rewards card?  Is that fair to the merchant?  Let us know what you think in the comments below!